Biggest Market Divergence in 15 Years Signals 10-20% Gain to Record

Stock outflows and bond inflows are diverging at the most extreme pace in 15 years, sending a bullish signal that equities could surge to new highs, according to a study by Bernstein. When similar, extreme bifurcations of flows between the two asset classes have happened in the past, equities have soared at least 10% and as much as 22% over the subsequent year, according to Bernstein, per a detailed story in Business Insider

Stock gains like these would catapult the benchmark S&P 500 index to new, all-time record levels given that the index now is trading about 2% below the all-time high it set in early May.

While the Bernstein study's implications are bullish, the firm says it will require a major catalyst or event to spark this upside movement. One highly regarded contrarian strategist, Chen Zhao of Alpine Macro, thinks he knows what that catalyst might be. Zhao is known for calling the tech bubble in 1998 and the start of the current bull market in 2009, and he now advises investors to go long on risk assets in anticipation of a U.S.–China trade deal, according to Bloomberg

How Stocks Soared After 5 Similar Events

(Dates of 5 stock–bond flow divergences: MSCI World Return 1 year after)

  • 05/2006 +22.34%
  • 12/2006 +10.00%
  • 06/2009 +18.15%
  • 05/2012 +16.85%
  • 06/2016 +18.04%

Source: Bernstein, Business Insider.

What it Means for Investors

Total equity-fund outflows this year have ballooned to $155 billion while bond inflows have surged to $182 billion, marking the largest bifurcation between bonds and equities in at least 15 years, per BI. Those massive flows are not letting up either. Last week saw the largest weekly bond inflows in more than four years at $17.5 billion, and $10.5 billion in outflows from equity funds.

“There are often tensions like this in the market, but the degree of this tension is at the extremes of historical experience,” wrote Bernstein senior analyst Inigo Fraser-Jenkins in a note to clients, per BI.

Such overextended conditions have historically preceded significant equity gains over the subsequent year, usually triggered by an event. And Alpine Macro's Zhao says such a trigger could come in the form of a resolution of trade tensions between the U.S. and China, the world’s two largest economies.

Zhao's analysis is that the recent intensification of the trade war between the world's two largest economies is part of U.S. President Trump’s ultimate goal to get the Federal Reserve to lower interest rates this year before settling a trade deal with China early next year. This would provide the economy and equity markets with a double boost during the final year of his presidential election campaign. 

“Once the Fed cuts, tariffs will get lowered. All risk assets will benefit. We’ll have no trade war, and stocks from the U.S. to China will go up. There’s a very high probability of that,” said Zhao, the former co-director of macro research at Brandywine Global Investment Management.

Looking Ahead

To be sure, a number of bears say it's more likely that the U.S.-China trade war will drastically slow corporate profit growth along with the global and U.S. economy, pushing the U.S. into a steep recession. Analysts at Citigroup, for example, see one possible scenario in which there is no trade deal and no rate cuts, sending equities into a bear market.

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